Mar 6, 2017
If you aren’t confused, you aren’t doing it right – Howard Marks, Oaktree Capital Management
Teenagers & Seniors
Howard Marks from Oaktree Capital recently visited India and called the U.S. a senior citizen and India a teenager country. Spot on. A teenager’s best days are ahead of it. Patience and a long view are required. Further, he stated that while it would be fruitful to identify turning points in developing markets such as the U.S. and Japan, India’s economy is on an upward trajectory and participation is the critical element.
Inflation Is Back… Worldwide
Inflation has picked up in the Eurozone, the U.S. and India. In India, the PMI Output Price index soared to 54, a new 3-year high, while the Wholesale Price index also rose to an alarming 5.25%. Let’s acknowledge here that the RBI got it right and the economist community didn’t. Eurozone inflation rose to 2.9%, putting Mr. Draghi in a bind. Further, U.S. headline inflation has risen to 2.5%.
Equities Normally Struggle in Periods of Rising Inflation
Bonds High Correlation to Inflation Is a Greater Cause for Worry
In India, PMI Output Prices Are Up to 53.4 and WPI Is Up to 5.25%
While in Europe Headline Inflation Has Hit 2% and the U.S. PCE Deflator Is Also Rising to 2%
Equity returns in a Rising Inflationary Environment are Muted, But Have Been Positive
Let’s consider the consequences of a sustained rise in inflation. Equities tend to struggle during periods of rising inflation. However, we would note that in both periods of rising inflation in recent years, equities have managed to deliver positive returns, albeit muted. So if sustained rising inflation lies ahead, this certainly suggests forward return expectations need to re-calibrate lower.
Our Call for a Bottom in Rates in December Was Well Timed, and Positioning in Bonds Remains Unchanged
Inflation is anathema for duration strategies. If we are in fact embarking on a rising rates environment, the close correlation between bonds and inflation clearly demonstrates that speculative duration will be a negative contributor to returns going forward.
Our call in November (“It Was the Best of Times”, 28-Nov-16) of a bottom in rates, starts to look well-timed.
Secondly, we remain comfortable with our positioning in Bonds; to wit, new funds should be deployed in accrual funds, and short duration, credit opportunity funds. Exposure to duration based strategies will be dependent on the competence of the fund manager. Moreover, we’d highlight active management for yield and upgrades becomes more essential than ever; in that regard, we’d continue to recommend AT-1 bond based strategies.
But Plummeting Credit Growth Due to Demonetisation Remains a Serious Concern for the Economy…
India Economy – Key Areas of Concern Remain
While Deposit Growth Has Skyrocketed, Credit Growth Has Plummeted
Call it the twin effects, one good, one evil. While deposit growth has exploded to the upside, the far more worrying event is the dramatic collapse in credit growth. We’d attribute this to the shock that the economy was plunged into as a result of demonetisation. It’s critical to see stabilization and recovery in credit growth to get to a healthy and broad based recovery.
Auto Sales Show the Pain in Rural Is Yet to Recover
Domestically, the auto industry continues to struggle in the rural areas. 3 wheeler sales were down 28% in January, scooters down 14.5%. Medium and Heavy Commercial vehicle sales are back to positive territory, but just barely. Light commercial vehicle sales remain tepid. However, utility vehicles continue to thrive and passenger car sales are healthy, highlighting the rural-metro and commercial-consumer divide.
Technically, the VIX Highlights the Complacency in the Markets…
Electricity, Steel and Cement Production Paint Varying Pictures
While electricity generation is growing in the low single digits, cement production is still down substantially, and Steel production in typical cyclical fashion is healthy, up 11.4%, in line with trends over the past few months.
Credit Offtake & NPAs Remain Key Concerns
Bank lending to industry remains the key issue. Growth is shrinking for the first time in over two decades. On lending, around $191bn, or 16.6% of the entire banking system, is now “non-performing”. Indeed, until demonetisation, consumer credit was booming, up by about 20% year on year. Sales outside the oil and metals sector were up a mere 5% year on year. Until these issues are resolved, the recovery will remain uneven at the macro level.
The VIX Is Highlighting Consensus Complacency
The India VIX is at a toppy level of complacency, and adds to our list of concerns. It verifies what we’ve been seeing in the market internals, which is that the index remains elevated due to a select few stocks but the vast majority of the market has not shown the typical health one would expect at this stage in the cycle. In all fairness, though, much of this lost momentum can be attributed to demonetisation.
We Concur with Howard Marks, It’s the 7th Inning of a 9 Inning Game in the U.S.
There are very few investors that command the track record and wisdom of Howard Marks. Mr. Marks ranks right up there with Charlie Munger. So when Mr. Marks says we’re nearing a bubble in the U.S., and Jeremy Grantham says the same, we can’t help but take notice. Using the Shiller PE Ratio (price divided by a 10-year lookback at earnings), domestic U.S. equities trade for 29.9x earnings versus a long run average of 16.7x.
U.S. Partying Like Its 1999…
Since election night, investors have put more money into stocks than they did throughout all of 2015. A whopping $8.2 billion piled into stocks in a single day just last week. So we’re back to partying like its 1999. Rarely do Americans buy stocks, generally they participate through 401(k)s.
While the Fed Is Adamant on Raising Rates
Fed Chair Yellen said today that a rate increase at the March FOMC meeting “would likely be appropriate”, as long as incoming data continue to confirm officials’ outlook. Given the data looks surprisingly healthy, not just in the U.S. but also in Europe, we think there is 90% plus likelihood the Fed will raise rates.
This Is a Problem for President Trump’s Plans
To implement his $1 trillion-dollar infrastructure plan, President Trump needs low rates and a weak dollar. Yellen is raising rates and strengthening the dollar. Something has got to give. The U.S. dollar’s recent fluctuations reflect uncertainty about the forward path for the economy.
In the Chaos Over the Short Term, the Simpler Answer Is To Extend Horizons
One can get a migraine thinking about all the positive and countervailing forces in the global economy today. These are the most complex and challenging markets we’ve ever tracked in over 20 years. However, it’s far easier is to consider the longer term perspective. In the longer term, we can state with conviction that the India story is stout, and stellar companies will continue to deliver stellar earnings growth.
There is plenty to worry about and volatility can often coax investors to abandon their investment plans. That will be the worst mistake. The S&P 500 suffered through two crashes in the past 17 years, and yet stands at new highs. Investors could obviously have done far better by avoiding the sell-offs and that remains one of our endeavours, to avoid crippling losses without ever jeopardizing portfolio performance.
Inflation, Credit and Rural Demand Remain Areas to Monitor
It is tough to be aggressively deploying capital with uncertainty over what Trump is likely to do, and what measures may be announced domestically. It’s also evident it’s taking the rural sector longer to emerge out of the doldrums.
While earnings were quite impressive and add a floor to our forecast, we’re equally enthused by the fact that earnings revisions for the Midcap index are up strongly, while earnings revisions for all indices are up.
We remain unconvinced in holding highly valued securities as they will be vulnerable during corrections. We are likely to see volatility at some point. Volatility should be used to build positions and deploy capital. The long term story remains intact. Our view on Equities remains unchanged.
Mid Cap EPS Estimate Revisions Are Up 20% YoY Versus 5.6% for the Nifty 50
To reiterate, inflation presents a danger to bonds. It’s unclear how strong the inflationary forces are, particularly as we’re also hearing chatter about a decline in Oil prices and Copper.
Regardless, reducing duration exposure would be a wise decision. We remain comfortable with our positioning in Bonds; to wit, new funds should be deployed in accrual funds, and short duration, credit opportunity funds. Exposure to duration based strategies will be dependent on the competence of the fund manager. Moreover, we’d highlight active management for yield and upgrades becomes more essential than ever; in that regard, we’d continue to recommend actively managed AT-1 bond based strategies.
The Nifty50 closed the week lower by 0.47% at 8897 levels. For the last couple of weeks index has been facing resistance at 9000 levels. In derivatives, Nifty 9000 strike price call option has the highest open interest and continues to see open interest addition leading to cap on the market for now. Momentum is also lacking as seen from stochastic indicator seeing a dip down. In spite of Thursdays fall from the highs, market witnessed long liquidation and India VIX measure of volatility saw a decline suggesting profit booking. On the downside Nifty has support at 8800 levels in the short term. Also in puts options 8800 strike options has the highest open interest followed by 8700 which is base for the market. The maximum open interest for call is at 9000 and puts calls at 8800, thus suggesting market is likely to trade between 8800 and 9000 in the near term. On the upside sustain above 9000 levels index is likely to rally towards 9119 it’s all time high and then 9225 levels. Break below 8800 levels market may see decline towards 8700 levels and then 8570 levels.